Bailout? What bailout?

I've been conducting an informal experiment for the past week or so. In the middle of a conversation, I'll casually ask the person what he or she thinks about the banking bailout. In almost every instance, my question elicits a response somewhere between a cynical snort and a vitriolic tirade. Nobody (so far) has been excited about it, but very few people have been ambivalent or agnostic. Almost everybody has an opinion.

Most people reading this blog are probably not surprised by the responses I recieved. But if you and I were sitting together having this conversation, I would now ask a different question and the resulting conversation might surprise you after all. I would ask, "Who was bailed out?" If you are like most of the subject of my surreptitious experiment, you might say "Well, you know...the banks!" I would probe a little deeper. "Do you mean the bank shareholders?" At this point, you might get a little annoyed and want to change the subject, but I would continue to press, because clarifying our understanding on this point gets to the heart of the issue.

Before I go any further, I need to make one point very clear: I loathe the idea that any tax payer money has gone to pay a bonus to anybody involved in causing the current financial crisis. Those bonuses were an abuse of the public trust and I believe that money should be returned to the tax payers with interest. However, excluding those abuses, the fact remains that the bailout did not provide a windfall to shareholders or managers. The truth is, the taxpayers - you and I - are the primary beneficiaries of the bailout. To illustrate my point, let's look at what has happened to the shareholders of some of the firms at the center of this crisis: Countrywide Funding, Citigroup, Washington Mutual, and Lehman Brothers.

Countrywide Funding
Countrywide Funding was one of the major culprits in the mortgage crisis. Partially through its efforts, subprime mortgages became a major proportion of mortgage originations in 2005 and 2006. If you owned shares in Countrywide during those years, you made a tremendous profit. However, what has happened to the value of your investment since? To find out, let's assume that you owned $10,000 worth of Countrywide Funding on December 31, 2006. By the end of 2007, your holdings would have dropped to $2,106 or a decline of 78%. If you continued to hold your same number of shares in hope that the sale to Bank of America would save you, the value of your holdings would have fallen to $980 by the time the merger was consumated. And if you still held your new shares in Bank of America in hope of the government rescuing you, your investment value would have dropped to $208 at the close of business yesterday. In all, owners lost 98% of their investment. It is hard to call that a bailout.

As the largest bank in the United States, and one of the largest in the world, Citigroup can't help but be involved in every financial storm. The current financial hurricane is no exception. Through its mortgage operations, Citigroup is one of the largest originators and services of residential mortgages in the country. Through its investment banking operations, it was one of the major players in creating esoteric mortgage-related securites, some of which turned out to be the toxic waste that precipitated this financial meltdown. If you had invested $10,000 in Citigroup at the end of 2006, it would have been worth only$5,526 by the end of 2007. By the end of 2008 it would fallen to $1,328 and, if you still held on to your position praying for a bailout to save you, your investment would now be worth only $700 for a loss of 93%.

Washington Mutual
WAMU, the largest thrift in the country, was the product of an acquisition binge that started after the S&L crisis in the late 1980's and continued through 2006. It introduced or actively promoted several innovations in the mortgage market that many now recognize were foolishly abused and severely weakened the overall capital markets. These innovations drove tremendous profit growth and allowed WAMU to outpace, and eventually acquire, many of its competitors. Unfortunately, the glory days did little to protect shareholders from the bank's collapse. A $10,000 investment at the end of 2006, shrank to $2,991 by the end of 2007. On September 15, 2008, the firm failed completely and the FDIC shuttered it. Branch offices and deposits were sold to JPMorgan Chase for a nominal amount, but the shareholders received nothing. They were literally wiped out.

Lehman Brothers
Lehman was another firm that had grown rich because of its deep roots in the mortage market. It was the leading underwriter of mortgage-related securities and was responsible for originating many of the toxic assets known as collateralized debt obligations or CDO's. As with the other firms highlighted in this post, the profits from these activities were astounding and the shareholders benefited from rapid earnings growth. In the early stages of the financial crisis, Lehman remained relatively unscathed. A $10,000 investment at the end of 2006 would have only lost 15% by the end of 2007. However, as the extent of Lehman's exposure to toxic assets became clear, the market lost confidence in Lehman's viability. In September of 2008, Lehman was forced to file for protection under Chapter 11 of the bankruptcy code. Shares now trade at around $0.03 for a near total loss to shareholders.

This not an attempt to generate pity for these firms or their owners. Rather, my point is to show that the market has been very effective in punishing the owners of firms that lie at the heart of our financial crisis. The efforts of the Federal Reserve and the U.S. Treasury did little or nothing to "bailout" these owners, but they did prevent a total collapse of our financial system. Given the rapid and huge dislocations in the world economy caused by the crisis as we have experienced it, we can only guess at how bad things might have been had the "bailout" not been pursued.